If you have not read my quick summary post, please do so before reading this one. I cover three topics in this post: how taxes are treated in the Joint Committee, how the spending cut trigger works, and the intentional imbalance of triggered spending cuts. All three are critical to the strategic analysis.

How taxes are treated in the Joint Committee

This bill does not raise taxes.

The $917 B of spending cuts that immediately take effect are just that, spending cuts. No tax increases there.

The Balanced Budget Amendment might or might not have a 2/3 voting requirement to raise taxes. That’s up to the House and Senate to decide when they vote on a BBA.

It gets complex when you look at the new Joint Committee. I think it’s easier if I break it into four questions:

If the Joint Committee process fails, could the automatic sequester mechanism raise taxes?

Yes, the Joint Committee is allowed to raise taxes. Nothing forbids the Committee from including any tax increase they like, if they have 7 or more votes to do so. But to become law that bill would also need the support of a majority of the House.

No for any taxes already scheduled to increase in the next 10 years under current law (e.g., the Bush-Obama tax rates, AMT, or any expiring tax extenders). Yes for any other proposed tax increase (e.g., corporate jets, Big Oil, carried interest, LIFO, capping itemized deductions for high income tax filers, or any other “new” tax increase). See below for more details.

The bill creates a 60 vote Senate budget point of order against legislation that would extend any of the Bush-Obama tax rates or patch the Alternative Minimum Tax. Then again, those bills already face a 60 vote filibuster threshold, and last year such a point of order existed against extending the top tax rates, so practically speaking, this isn’t a new or higher hurdle.

Details on #2 and #3

The Joint Committee can choose to raise taxes if a majority of the 12 members agree. This would require at least one of Speaker Boehner’s three or Leader McConnell’s three appointees to agree to raise taxes. The more important question is: would such tax increases count toward the Committee’s $1.5 T deficit reduction target?

The key technical detail is that the Committee’s recommendations on taxes will be measured against a current law baseline for taxes. Under current law, certain taxes are scheduled to go up in 2013, most notably the individual income tax rates and rates on capital gains and dividends. Normally Republicans dislike a current law baseline on taxes, but in this case it helps them.

Here’s what that means for the Joint Committee:

If the Committee allows tax rates to increase in 2013 (aka “raise tax rates in 2013,” or “let the Bush-Obama tax cuts expire,” depending on your point of view), the additional revenues raised will not count toward the Joint Committee’s target since this is already current law. So raising these tax rates doesn’t help the Committee meet their $1.5 T deficit target. That doesn’t mean they can’t include them in their legislation (they can), just that they can’t get any numeric benefit for doing so. That is incredibly important.

The same is true for capital gains and dividends. While a majority of the Committee could agree to allow those rates to increase, they won’t get any numeric benefit from doing so (unless they were to go above the 20% scheduled for current law starting in 2013).

The same would be true for the alternative minimum tax. If the Committee were to decide to let the AMT bite a lot more people, they wouldn’t be scored with any additional revenues raised to meet their deficit reduction target, since that is already scheduled to happen under current law.

The same would be true for any tax extender-like provisions scheduled to expire under current law (e.g., the ethanol tax credit). Allowing them to expire (or scaling them back) won’t get scored as deficit reduction for the Joint Committee because they are already scheduled to expire under current law. It won’t move them any closer to their goal.

But other “new” tax increases would count toward the Joint Committee’s deficit reduction target. If the Committee eliminates depreciation for corporate jets, for instance, or or repeals or scales back carried interest or LIFO, or caps itemized deductions for high-income tax filers, those would score as tax increases relative to current law, and the Committee would get credit for deficit reduction for including those tax increases.

Therefore, if the six committee Democrats can convince one of the Republicans to raise taxes, they have an incentive to raise new taxes rather than tax rates on income, capital gains, or dividends. The tax rate fights are most likely to occur outside this process.

In any case, if 218 House Republicans don’t want to raise taxes, they can kill the Joint Committee’s recommendations, triggering the automatic spending cuts. There is, however, a downside to that for Republicans …

How the spending cut trigger works

First, it’s a spending cut trigger. It does not and cannot trigger any tax increases.

Second, the trigger kicks in only if the Joint Committee process fails to result in a new law enacting deficit reduction of at least $1.2 T over the next 10 years.

The trigger would cut spending by ($1.2 T minus the amount of deficit reduction enacted into law through the Joint Committee process).

The trigger would cut all discretionary spending, Medicare, farm subsidies, mandatory housing subsidies, and a few smaller mandatory spending programs. Social Security, veterans’ benefits, civilian and military retirement, and all low-income subsidies including Medicaid and the “welfare” programs (food stamps, SSI, etc.) would be exempt from the trigger. Net Interest payments would also be exempt.

The spending cuts are split evenly (measured in dollars) between two pots:

defense discretionary;

nondefense discretionary + covered entitlements.

As in the 1997 budget law, the cut to Medicare is capped at 2%.

The imbalance of triggered spending cuts

If the Committee fails altogether or comes up short of its $1.2 T deficit reduction target, the triggered spending cuts kick in. The automatically triggered spending cuts are designed to cut defense discretionary spending by a greater percentage than nondefense discretionary spending. Since the dollar amount of the cuts are allocated 50/50, and the nondefense discretionary spending also has Medicare and about $50 B of other annual entitlement spending in its base, the cuts to nondefense discretionary spending are diluted by the cuts to the included entitlements.

Example: Suppose the Joint Committee process fails completely and no law enacts new deficit reduction this fall. Just s’pose.

The trigger then must cut spending by $1.2 T over ten (actually, nine) years. Here are the mechanics of how those spending cuts are allocated.

First back out interest savings (18% of the total, or $216 B). That leaves $984 B of spending cuts.

Spread that out evenly over nine years. That means cut spending by $109 B per year for each of FY13 – FY21.

Split that $109 B evenly between (defense) and (nondefense + some mandatory). So each category takes about a $55 B hit in each of the next nine years.

That would result in about a $54 B cut in defense discretionary spending in FY13.

The other $55 B in spending cuts gets applied to (nondefense discretionary + Medicare + some other entitlements). But the cut to Medicare is capped at 2%.

The result of this is that nondefense discretionary and these other entitlements would take about an 8% cut.

Therefore:

Defense discretionary spending would be $546 B if the Committee hits its target, and about $492 B if the Committee fails entirely. That’s 10% less, a $54 B cut in defense discretionary spending in 2013.

Nondefense discretionary spending would be $501 B if the Committee hits its target, and about $461 B if the Committee fails entirely. That’s 8% less, a $40 B cut in nondefense discretionary spending in 2013.

Medicare spending would be cut 2% in 2013.

Farm programs and a few other entitlements would be cut 8% in 2013.

Note that in both cases, the discretionary percentage cuts are on top of the 2013 share of the $917 B of discretionary spending cuts enacted when the Budget Control Act is signed. Discretionary spenders will correctly argue that they are paying once up front to offset the initial $900 B debt limit increases, and then again to offset almost all of the $1.2 T debt limit increase if the Joint Committee process fails.

A key strategic point is the relative pain applied to the two parties’ spending priorities. In this example where the Joint Committee process fails, defense takes a 10% cut on top of its share of the initial $917 B cut, while nondefense takes an additional 8% cut and Medicare takes a 2% cut.

This imbalance is intentional and was key to reaching agreement on the Budget Control Act. It’s also critical to how the Joint Committee might work.